Finding an edge; creating a moat around an investment process
I wanted to share this video of a presentation I recently watched by small cap investor Brian Bares, founder of Bares Capital Management.
As I tweeted last week, this was one of the best investment lectures I’ve ever seen, full of practical advice surrounding how to truly create an edge with an investment process, where market-beating returns come from, and what sort of behavioral characteristics are needed to be a successful active manager.
It’s no surprise that Brian has had plenty of success in the industry, after starting his firm around 2000 with $21,000 of his own money, and a small office in Austin, Texas.
Some of my notes from the presentation are below, and the video is posted at the bottom. I highly recommend taking 90 minutes to listen and absorb the information.
No real barriers to entry in the investment business other than:
Youth and inexperience
Lack of a track record
Chicken and egg problem – getting assets
Brian explains it’s much easier to go from say $2 billion to $6 billion than it is to go from $0 to $1 million
Bares Capital strategy for small cap was to go after institutional clients, not HNW
a sustainable edge that produces good results
concentrated and qualitative – 10 stock portfolios
Concentration is hard. Why is it hard?
It’s really embarrassing when it doesn’t work
Hard choices, easy life; easy choices, hard life
Bares Capital wanted to do the things that most manager won’t/can’t do – concentrated, deep research, feet on the ground due diligence
A rocky path can lead to outperformance over time – because one is doing things that other’s don’t do
Plenty of incentives to diversify – but they are trying to outperform, not look like an index
How to build something totally differentiated
Start by thinking about how to build something undifferentiated (invert)
Screen on high ROE
Identify Buffett characteristics
Rely on industry standard tools – Bloomberg, TV, fees – plenty of managers lack confidence in their investments, so they look to others to confirm (i.e. – can I talk to you about this company you own, that I also own?)
Stock prices follow per share business value growth
Exceptional share price performance comes from exceptional compounding
Exceptional intrinsic value compounding
Growth that is underappreciated by the market
How can a company potentially grow in a way that other market participants aren’t focused?
Bares Capital investment process moat
Team – 15 people on the phone, and in the car
Focus on three things exclusively (moats, management, underappreciated growth)
Have the discipline to structure our strategies so they can’t be replicated
For example: Goldman can’t start a concentrated 10 stock portfolio in small caps – doesn’t generate enough fees
Important to remember that moat does NOT mean edge
A moat is hard to replicate, but just because it’s hard to replicate doesn’t mean it’s any good!
The edge is producing the variant perception which leads to the outperformance
What is an investment edge?
A repeatable sourcing of variant perception that leads to sustained outperformance
Processing the information differently
Two parts to an investment edge
Build something that’s hard to replicate
Create sources of variant perception that lead to outperformance
Everything in the investment management business revolves around sales
Selling yourself, selling to your colleagues, selling an idea or a stock
Raising money requires talking to people who want to give it to you
Difference between someone with high AUM and low AUM is their ability to sell and their dislike or like of the sales process
If you’re a high teens compounder, you need the other part of the skillset which is selling ability
Need entrepreneurial drive to make this work
You have to live or die by your own sword – assume it’s going to work. Coming across as insecure means you won’t get any money. I’m going to go from here to there, and either you’re coming with me or you aren’t
Meeting with management teams
Understand what they’re working on and why they’re working on it
Have a list of questions
Understand things you can’t get from the proxy or 10K filings
Don’t waste anyone’s time
Try to see things in action, if there are things to see – culture, machinery, competitive advantages etc.
Due diligence depends on how much there is to see
Sometimes takes years, others times a buy can be made after a few months
Maybe not as much to see with non-technical businesses
If there is a process or something that requires signing an NDA after, you probably want to see that
Work really hard to be dispassionate about your purchase price
If the competitive story changes, you have to sell
Do what’s rational and dispassionate when it comes to the portfolio